Who’ll pull the trigger on the eurozone?

Published in Business Spectator (Melbourne), 6 December 2012

One of the most oft-quoted sayings in economics is Herbert Stein’s famous dictum that if something cannot go on forever, it will stop. It is so often quoted because it is logically true. It certainly holds for the construction of the eurozone and the design of those policies to rescue it.

Regrettably, Stein did not specify how such unsustainable mechanisms come to an end. But recent developments in the euro crisis suggest a gradual process culminating in a tipping point. We may be nearing this moment.

I have lost count of the emergency summits on Greece over the past few years, but last week’s summit ended like all the dozens of summits before.

Wolfgang Schäuble, the German finance minister, called it “a good result” that parliaments should now approve. Greek Prime Minister Antonis Samaras poetically spoke of “a new day” for all his fellow countrymen, and even IMF chief Christine Lagarde applauded a “satisfactory solution” for Greece.

So in short, it was business as usual. The same statements we have heard for the past three years, from mostly the same politicians, for still the same basic problem: to save Greece from imminent sovereign default.

And yet something was different. There was no sigh of relief, let alone euphoria about the result. Markets were not impressed by the new lifeline for Greece; media commentators did not pretend that this was more than a stop-gap measure; and opposition in the richer euro countries against a continued bailout for Greece is visibly growing.

As if that was not bad enough for the professional euro rescuers, the downgrading of the EFSF and the ESM funds by ratings agency Moody’s a few days later signalled that time for (dare I say: traditional?) euro stabilisation policies is running out.

Taking away all the official gloss put on the euro policies over the past three years, the results are less than convincing. What started with a local crisis in a small country on the European periphery has become a seemingly permanent state of emergency for the whole of the eurozone. As a result of the European Union’s stubborn policies, the problem grew larger, engulfing more countries along the way.

It also grew bigger. Remember how initially the Greek problem seemed solvable by just a few billion euros of assistance? By contrast, the current rescue mechanisms including the two bailout funds (EFSF and ESM), combined with the measures taken by the European Central bank like Target 2 and the indirect LTRO bank bailout, can be counted in the trillions of euros.

If only there were signs that the European economy was moving in the right direction, namely towards recovery, perhaps those enormous sums of money mobilised for the stabilisation of the euro could be more easily accepted. Yet all economic indicators point towards an ossification of the crisis. To find any traces of eurozone growth requires a magnifying lens, while unemployment within the currency bloc has reached 11.7 per cent. A staggering 18.7 million people in the eurozone are without a job – and this is only the official figure. Hidden unemployment is much higher.

Clearly, then, Europe is the sick man of the world – no matter what Schäuble, Samaras, Lagarde and co try to pretend. Since there are no signs of improvement but indications of deterioration, this leads us back to Stein’s observation. If it is such an unsustainable state of affairs, when will it ever change? And what will be the trigger?

To my mind, there are two such triggers for the euro crisis. Both would have the potential to fundamentally change the big picture, and both are looking more likely after the events of the past few weeks.

The first such trigger is a realisation by market participants that those countries underwriting the bulk of the eurozone’s rescue mechanisms are not nearly as strong as previously believed. Although formally both the EFSF and the ESM are guaranteed by all eurozone members, in effect only two of them really matter for the trust in these institutions: Germany and France.

The other countries are either too small to make a difference (e.g. Luxembourg, Austria or Finland), or nobody ever believed that they would contribute to these funds anyway (e.g. Portugal, Spain or Italy). Finally, there are countries that are both too small and too poor to pay for others (e.g. Cyprus or Malta). This really only leaves Germany and France.

With Moody’s downgrade of France’s rating, we may have entered a phase in which the economic health of the two bedrocks of the eurozone is being questioned. This also explains Moody’s downgrade of the euro rescue funds. It may only be the beginning. If Germany goes into recession next year, as a growing number of analysts now forecast, the spotlight will be on the supposed anchor of the eurozone.

On closer inspection of the Germans’ long-term fiscal and demographic projections, it should become apparent quite quickly that they are in no position to bail out the rest of Europe. In coming years they will be busy enough dealing with the effects of their own ageing and shrinking population.

There is a second trigger that could bring all previous stabilisation strategies to an end: When they finally cost the guarantor countries hard cash.

Last week, the German public got excited about the fact that with the amended measures for Greece, the bailout of the eurozone periphery will (for the first time!) actually cost them real money. The federal budget will take a hit of €730 million next year. It may seem bizarre, but many Germans were genuinely surprised that bailouts cost anything.

That surprise will turn into astonishment and anger when they discover that those measly €730 million were only the beginning of a much bigger bailout. Faced with cash demands in the dozens of billions, how likely is it that political majorities will still be found for such programs? At last week’s parliamentary vote in the Bundestag, there were already a record number of ‘no’ votes and abstentions.

The eurozone in its current form is not sustainable, certainly not with the current bailout policies. Will markets realise that no country can effectively guarantee its survival? Or will the guarantors finally understand the burden of their commitments? We will find out over the coming months.